1 Learning Objectives for Sections 3.1-3.2 Simple & Compound Interest After this lecture, you should be able to Compute simple interest using the simple.

1

Learning Objectives for Sections 3.1-3.2 Simple & Compound Interest

After this lecture, you should be able to Compute simple interest using the simple interest formula. Solve problems involving investments and the simple interest

formula. Compute compound interest.

2

Some Preliminary Notes

Financial institutions often use 360 days for one year when computing time.

Time must be in terms of years to use in the formulas.

All rates (%) must be converted to decimals to use in formulas.

When an answer is rounded, use the symbol instead of =.

We will round to the nearest cent for dollar amounts, unless otherwise stated.

Try to avoid rounding until the final answer.

3

Conversions: Time Periods

Example 1: Convert the given time periods into years:

a) 180 days b) 120 days c) 3 quarters

d) 7 months e) 60 days f) 26 weeks

4

Conversions: Percents to Decimals

Example 2: Convert the given percents to decimals:

a) 4.5% b) .32% c) 112%

5

Conversions: Decimals to Percents

Example 3: Convert the given decimals to percents:

a) 0.06 b) 5 c) 0.11

6

Simple Interest Formula

Simple Interest Formula

where I = interest

P = principal (amount invested or amount of loan) r = annual simple interest rate (as a decimal) t = time in years

I Prt

7

An Example

Example 4: Find the interest on a boat loan of $5,000 at 16% for 8 months.

Example 5: What is the total amount to be paid back on the boat loan in Example 4?

8

Total Amount to Be Paid Back

In general, the future value (amount) is given by the following equation:

A = Principal + Interest

A = P + I

A = P + Prt

A = P (1 + rt)

9

Another Example

Example 6: Find the total amount due on a loan of $600 at 16%

interest at the end of 15 months.

10

Another Example

Example 7: A loan of $10,000 was repaid at the end of 6 months.

What amount (principal and interest) was repaid, if a 6.5% annual

rate of interest was charged?

11

Application

Example 8: A department store charges 18.6% interest (annual) for overdue accounts. How much interest will be owed on a $1,080 account that is 3 months overdue?

12

Purchase Price of a Note

Example 10: What is the purchase price of a 26-week T-bill with a maturity value of $1,000 that earns an annual interest rate of 4.903%?

13

Compound Interest

Compound interest: Interest paid on interest reinvested.

Compound interest is always greater than or equal to simple interest in the same time period, given the same annual rate.

14

Compounding Periods

The number of compounding periods per year (m):

If the interest is compounded annually, then m = _______

If the interest is compounded semiannually, then m = _______

If the interest is compounded quarterly, then m = _______

If the interest is compounded monthly, then m = _______

If the interest is compounded daily, then m = _______

15

Example

Example 1: Suppose a principal of $1 was invested in an account paying 6% annual interest compounded monthly. How much would be in the account after one year?

Continued on next slide.

annual rate

# of compounding periods per year

The annual interest rate is 6%, so the monthly interest rate would be:

0.06

12

In general, we can find the rate per compounding period as:

16

Solution

Solution: Using the Future Value with simple interest formula A = P (1 + rt) we obtain the following amount:

after one month:

after two months:

after three months:

After 12 months, the amount is: ________________________.

With simple interest, the amount after one year would be _______.

The difference becomes more noticeable after several years.

17

Graphical Illustration ofCompound Interest

The growth of $1 at 6% interest compounded monthly compared to 6% simple interest over a 15-year period.

The blue curve refers to the $1 invested at 6% simple interest.

The red curve refers to the $1 at 6% being compounded monthly.

Time (in years)

Dol

lars

18

The formula for calculating the Future Amount with Compound Interest is

Where

A is the future amount,

P is the principal,

r is the annual interest rate as a decimal,

m is the number of compounding periods in one year, and

t is the total number of years.

General Formula: Compound Interest

1mt

rA P

m

19

Example

Example 2a: Find the amount to which $1,500 will grow if compounded quarterly at 6.75% interest for 10 years.

Example 2b: Compare your answer from part a) to the amount you would have if the interest was figured using the simple interest formula.

20

Changing the number of compounding periods per year

Example 3: To what amount will $1,500 grow if compounded daily at 6.75% interest for 10 years?

21

Effect of Increasing the Number of Compounding Periods

If the number of compounding periods per year is increased while the principal, annual rate of interest and total number of years remain the same, the future amount of money will increase slightly.

22

Example

Example 4: If $20,000 is invested at 4% compounded monthly, what is the amount after a) 5 years b) 8 years?

23

Which is Better?

Example 5: Which is the better investment and why: 8% compounded quarterly or 8.3% compounded annually?

24

Inflation

Example 6: If the inflation rate averages 4% per year compounded annually for the next 5 years, what will a car costing $17,000 now cost 5 years from now?